Thank You

Error.

"Don't be afraid to make a mistake. But make sure you don't make the same mistake twice," Akio Morita, the great co-founder of Sony, once said. That, in a nutshell, is why global investors are predisposed to tread lightly in Japan, stepping in on any whiff of reform, and hopping out on evidence that change is coming glacially. Deflation, a torpid economy, and a lack of conviction are key reasons the market is still some 60% below the high it set in 1989. Global investors took flight from Japanese equities again in mid-2013, as plans to raise the sales tax suggested that more stagnation lay ahead.

Yet, the managers of the
MainStay ICAP International
fund (ticker: ICEUX) have recently -- and dramatically -- increased their allocation to Japanese stocks, to 22% of the $2.4 billion fund, up from just 15% in December. "Japan may be uniquely attractive," says Jerrold Senser, the fund's longest-serving manager. "People are underappreciating the structural reform under way."

Senser is the chief executive of Chicago-based Institutional Capital, which runs $28.7 billion in assets and several funds for parent New York Life. ICAP seeks value plays with catalysts that will drive the shares higher, including management initiatives, new products, and newly friendly attitudes to investors. Thomas Cole is its deputy chief investment officer.

MainStay ICAP International has had a tough couple of years because of an early bet on Japanese names, which suddenly flagged last year on doubt about Prime Minister Shinzo Abe's reforms and worries the Japanese recovery would backslide. Indeed, net foreign buying in Japan has been halved from a year ago, according to Credit Suisse. But there have been other missteps: Senser and his team's skepticism of last year's rally in European financials hurt, as did this year's nascent recovery in China (the fund has little exposure to emerging markets). Ultimately, the fund bought more of European bank
Julius Baer Gruppebaer.vx -1.2468827930174564%Julius Baer Gruppe AGSwitzerland: SWX EuropeCHF43.56
-0.55-1.2468827930174564%
/Date(1425425496000-0600)/
Volume (Delayed 15m)
:
494022
P/E Ratio
25.98868007181192Market Cap
9872234424.72744
Dividend Yield
1.3774104683195592% Rev. per Employee
546984More quote details and news »baer.vxinYour ValueYour ChangeShort position
(BAER.Switzerland) and Japanese companies. "They're worthy investments," Senser maintains; the increased exposure will help when the market reverts to the mean. Over the long haul, the fund has a stellar record, beating 87% of its peers over 10 years, and 76% over 15. Senser has helped lead the fund since its 1997 inception.

Japan is the firm's latest big wager now that it has retired a longtime theme called "the strong get stronger" (companies like BB&T and JPMorgan Chase that during the downturn were able to snap up distressed assets), and another -- "earn and return," companies that are returning capital to investors -- is getting long in the tooth.

Key to Japan's newest round of structural reforms are health-care overhaul, deregulation of the agriculture sector, new measures to encourage women to work full- time, and a plan to reduce corporate taxes from 35% to less than 30%. What especially gets Senser and his co-manager Cole going are Abe's plans to make the market more shareholder-friendly. These include requiring companies to appoint more outside directors, and helping create the JPX-Nikkei 400, whose 400 constituent companies (equal to about 20% of the broad-based Topix index) must meet certain targets for returns, financial strength, corporate governance, and other shareholder-friendly measures. "There's a degree of status that will be accorded to companies that will be included in this index," says Senser. (Ironically, Sony's profit woes mean it isn't in the index.)

Corporate Japan has suffered from the worst returns on equity in the developed world; as a result, price-to-book ratios are low. The new JPX-Nikkei 400 will help lift returns, Senser and Cole say. The Bank of Japan is considering buying funds that track the index as part of its purchases, and the $1.3 trillion government pension fund will buy more stocks. Says Cole: "The thought is that the allocation to equities will increase from 12% to 20%, which obviously is a big deal, and that the government will be steering those dollars to the Nikkei 400."

MainStay ICAP Intl Value

Total Returns*

1-Yr

5-Yr

10-Yr

ICEUX

7.5%

7.7%

8.0%

MSCI EAFE

10.5

8.4

7.1

% Of

Top 10 Holdings

Ticker

Portfolio**

Nippon T & T

9432.Japan

5.0%

Total SA

FP.France

4.4

ENI SpA

ENI.Italy

4.4

Mitsubishi

8058.Japan

4.3

Novartis AG

NOVNEE.Switz.

4.3

Bayer AG

BAYN.Germany

4.2

Vodafone Group

VOD. U.K.

3.8

Tokio Marine Hldgs

8766.Japan

3.5

BCE

BCE.Canada

3.4

Lloyds Banking

LLOY.U.K.

3.4

Total:

40.7

*All returns are as of 8/13; three- and five-year returns are annualized. ** As of 6/30. Sources: New York Life; Morningstar

If anything represents the sprawling nature of Japan Inc., it's
Mitsubishi 8058.to -0.41675349031048137%Mitsubishi Corp.Japan: TokyoJPY2389.5
-10-0.41675349031048137%
/Date(1425416400000-0600)/
Volume (Delayed 20m)
:
4394400
P/E Ratio
9.651425801761047Market Cap
3896876181625
Dividend Yield
2.5109855618330195% Rev. per Employee
113211000More quote details and news »8058.toinYour ValueYour ChangeShort position
(8058.Japan), one of the fund's largest holdings. Mitsubishi is Japan's largest general trading company, dealing in metals, energy, chemicals, and food. In May 2013, the company announced a plan to improve free cash flow, shed lower-return businesses, and raise returns to shareholders. It announced a 60 billion yen ($585 million) share repurchase, and plans to boost its dividend; the prospective yield is 3.4%. Then there is capital appreciation: Mitsubishi currently trades at 0.7 times book value, compared with its historical average of 1.4. "Management has taken very tangible steps to improve returns," says Senser. The stock is "dirt cheap, and given the cash-return policy and valuation, we think it is very attractive."

Another top holding is
Mitsubishi Estate8802.to 0.819672131147541%Mitsubishi Estate Co. Ltd.Japan: TokyoJPY2767.5
22.50.819672131147541%
/Date(1425416400000-0600)/
Volume (Delayed 20m)
:
5870000
P/E Ratio
37.510165356465166Market Cap
3816639765000
Dividend Yield
0.43360433604336046% Rev. per Employee
136762000More quote details and news »8802.toinYour ValueYour ChangeShort position
(8802.Japan), an office-leasing company whose main buildings are in Tokyo's Marunouchi business district. Recently, it has pushed through rent hikes of 10% to 20%, says Cole. That "augurs good numbers" as the company reports results in coming quarters. Meanwhile, though the stock's valuation suggests that the "cap rate" on Mitsubishi's properties -- the rate of return based on a property's expected income -- is just under 5%, the company's latest deals suggest a cap rate "in the mid-3% range," implying that future prices will be sharply higher. Mitsubishi Estate shares have risen to a recent ¥2,389, but "on the basis of our work, we're getting a target price that's far higher," Cole says.

To be sure, there are continuing concerns about the economic effects of Japan's sales-tax increase to 8% from 5% in April, the first consumption-tax increase in 17 years. The increase is aimed at addressing Japan's large public debt.

Still, there's evidence the economy is more robust than people believe. Private consumption and capital spending are holding up better than feared; many companies are suffering from a labor shortage; a steady series of price increases suggests that deflation is finally over.

"What's important to us is a good valuation and a strong catalyst," Senser says. Right now, Japan is rich in both.